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Do you report under GAAP or IFRS? If so, you are most likely large enough to have both equipment and real estate leases in your portfolio. After speaking with hundreds of companies, we discovered that historically these have been tracked in different departments. Both real estate and equipment operating leases are currently reported as off-balance sheet transactions. The exception to this is capital leases. (Here is a free accounting tool for capital lease vs operating lease).

Typically, the Real Estate department handles the signing and tracking of real estate leases. The information is then sent to the Accounting department each reporting period. Equipment leases are signed and tracked by multiple departments, ranging from fleet and facilities management to IT, who also send information to the Accounting department at each reporting period. Since this process is not under a single department, it is not uncommon for several leases to get lost in the translation to the accounting department. The real estate leases are typically more material because of the higher lease obligation so, the equipment leases end up being missed most often (Use this free lease accounting transition guide to identify more departments to find missing leases).

Most leasing software on the market started as lease management or administration software and was built for real estate professionals. Because all operating leases were previously off-balance sheet transactions, the accounting functionality was not a high priority. The people who developed these software packages have real estate backgrounds because that was the most important knowledge to have in building the solutions at the time. That all changed in January and February of 2016 when both the FASB and IASB released significant changes to the lease accounting standard (read more about the lease accounting changes here).

We have put together this quick list of questions to ask any potential lease accounting software vendor so you can make an informed decision and understand if they are the best choice to handle both your real estate and equipment leases.

In today’s blog post, we will discuss and explain capital lease accounting. We will utilize a detailed example to illustrate the accounting entries involved, but let us stress that this example covers capital lease accounting under CURRENT accounting rules by the FASB and IASB –Topic 840/FAS 13 and IAS 17 respectively. In a subsequent blog post, we will address “Finance” lease accounting under the NEW Lease Accounting Standards issued by the FASB and IASB—Topic 842 and IFRS 16, respectively (under Topic 842, capital leases will be called finance leases).

As a refresher, a capital lease is one in which a lessee records the leased asset as if it purchased the asset using funding provided by the lessor. As a result, capital lease accounting under current GAAP is actually comprised of two transactions: A purchase of the underlying asset by the lessee AND a loan to the lessee from the lessor to fund the purchase of said asset.

A lessee should record a lease as a capital lease and therefore apply capital lease accounting if ANY of the following criteria are met:

First Criterion: Ownership of the underlying asset transfers to the lessee after the lease term; or

Second Criterion: There is a “bargain purchase option”, meaning that the lessee has an option to buy the underlying asset after the lease term at a price that’s below-market; or

Third Criterion: The lease term is 75% or greater than the useful life of the underlying asset; or

Fourth Criterion: The present value of the minimum lease payments is at least 90% of the fair value of the asset.

This article was contributed by LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact here.

In this blog post, we will explain how deferred rent affects income tax under current lease accounting rules. We want to stress that this blog post covers it and income taxes under CURRENT rules of lease accounting (Topic 840). In a subsequent post, we will cover income taxes under Topic 842, which is the new lease accounting rules.

Before we delve into an example, let us recall the definition of deferred rent:

It is the liability that is created as a result of the difference between the actual cash paid and the straight-line expense recorded on the financial statements.

One of the basic principles of Topic 740 (Income Taxes) is that deferred taxes have to be recognized for temporary differences between the financial statements and tax returns. To put it another way, these deferred taxes are recognized for future tax consequences of events recorded in either the financial statements or the tax return, but not yet in both. Deferred tax liabilities are recorded for taxable temporary differences while deferred tax assets are recorded for deductible temporary differences.

The vast majority of the time, the deferred rent recorded is the difference between the straightline rent recognized for book purposes and the rent deductible for tax purposes (which is usually the cash paid). Under CURRENT GAAP for lease accounting, a lessee would generally record a deferred tax asset for the deferred rent liability recorded on the books. In addition, initial direct costs (IDC) are capitalized for tax purposes unless they are de minimus (meaning that they do not exceed $5,000 in the aggregate for US Federal purposes).

To demonstrate how deferred rent works in practice, let’s work through a simple illustrative example:

Lessee leases a building from a lessor, and the lease is classified as an operating lease.

Lease term is 10 years.

Rent payments are $100,000 in the first year, escalating 3% per year. Payments are made in arrears.

Note 3: The deferred rent in this example is a plug that will make the entry balance, or it can be calculated as the straight-line expense less the cash paid each year. (Deferred rent here equals total lease payments of 1,146,388 divided by 10 years less cash paid of 100,000).

At the end of the first year, the Lessee’s deductible expenses for tax purposes is 101,000 (actual cash paid plus Year 1 amortization of the IDC), as a result, the lessee would record a current tax benefit of 30,300 (101,000 X 30%). The journal entry to record this is:

Account

Debit

Credit

Income Taxes Payable

30,300

Current Income tax expense

30,300

As noted in the second paragraph of this post, deferred taxes have to be recognized for temporary differences between the financial statements and tax returns. The lessee’s deductible expenses for tax purposes is 101,000; while lease expense for book purposes is 115,639 (see note 1 above). The deferred rent of 14,639 constitutes a temporary difference that needs to be tax-effected to determine the associated deferred tax asset. The deferred rent would be multiplied by the tax rate to give the following entry:

Account

Debit

Credit

Deferred Tax Asset4

4,392

Deferred Income Tax Expense

4392

Note 4: Deferred rent of 14,631 multiplied by tax rate of 30%.

Based on the entries above, note that the total income tax benefit is 34,692, which equals 30% of the recorded book expense of 115,639.

Once again, the entries above reflect the journal entries for deferred rent and the related tax effect under current lease accounting rules. In a subsequent post, we will explain the tax effect of leases under topic 842.

This article was contributed by LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact here.

This is the second of a two-part series: 6 Lease Accounting Errors You’re Probably Making (And How to Fix Them). Our previous post addressed the first 3 common accounting errors we have found after reviewing thousands of leases. To summarize, those common errors were:

This article was contributed by LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact here.

One thing that makes LeaseQuery different from other lease management software providers is that we are not just real estate professionals; we are also accountants. Why is that important? Well, when you start using our software, we perform two tests on your leases to ensure the following:

1st Test: We make sure that you are making the correct payments based on the lease documents and,

2nd Test: We make sure that your existing leases are complying with GAAP.

While most of the existing lease software out there can perform the first test, the second assessment is more important because even though the correct payments are being made, the entries being recorded may be incorrect. Only accountants can make that determination. In today’s column, we will show you the top 6 accounting errors we have found after our evaluation of numerous leases.

Contributed by LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact here.